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The Equity Market Sentiment level is essentially a “how do you feel today?” test. The market is essentially just a large group of people who want money, and everything is designed solely to earn and avoid losing money. It (they) can feel confident. It (they) can feel scared. You can take advantage of both.

When the market transitions from confident to fearful it is a great time to take short positions. When the market transitions from fearful to confident it is a great time to take long positions. You can be a contrarian and short when the market is confident and buy when the market is fearful, like Warren Buffett, but this is dangerous. You have no idea how long the market will continue to feel the way it does, and you can take heavy losses waiting for a market to turn around. Trading with an established trend is safer for long or single positions, even if the trend is recently formed. You don’t need to be in before the trend begins, you merely need to catch the majority of any trend.

There are multiple sentiment indicators that you can look at to determine the sentiment of the market. My quick preference is CNN’s “Fear and Greed” Index, which combines many sentiment indicators into a single indicator. It combines: Demand for Junk Bonds, The Put and Call Ratio, VIX Volatility, Safe Haven Demand, Market Momentum, High/Low Ratio, and the McClellan Volume Summation.

Demand for Junk Bonds

Junk Bonds are bonds below BB/BA rating, which means their issuers have shaky credit scores that are at high risk for default. These bonds typically pay higher interest rates as compensation or have lower prices relative to their interest rates. The result is a higher yield, since yield goes up as price relative to interest rates goes down. A lower yield spread for junk bonds over investment grade bonds equates to more greed. Investors are buying junk bonds, pushing up prices, and lowering yields. The investors aren’t worried about likeliness to default. A higher yield spread for junk bonds over investment grade bonds equates to more fear. Investors are avoiding junk bonds, and suspect situations that will cause defaults on interest payments are likely.

Put Call Ratio

The put call ratio is determined by dividing the volume of Put options (derivative bets prices will fall) by the volume of Call options (derivative bets prices will rise). Higher put volume results in a ratio above 1, and is fearful since majority of people suspect a price fall. Higher call volume results in a ratio below 1, and is greedy since people suspect a price rise.

VIX Volatility

The CBOE Volatility Index is a measure of the sharpness of price movements. In highly fearful environments, volatility typically spikes up north of the long term average. A higher reading typically is seen as fearful, but in sharp rallies market volatility can also rise.

Safe Haven Demand

Safe Havens are investment classes and instruments that retain their value when the market is crashing. Safe Haven demand increases as the market increases in fear, and decreases when the market decreases in fear. This category typically includes specific currencies (Japanese Yen, Swiss Franc, and US Dollar versus smaller economies), Gold, and Investment Grade Bonds. A higher demand becomes obviously fearful.

Market Momentum

A consistent fall in market momentum is fearful, and a consistent rise in market momentum is greedy. This is better measured against a longer term moving average, like the 125 day moving average or the 200 day moving average. It should also be measured against a peak or a trough in the market. The further above a trough and rising, the greedier the market, especially if maintaining momentum above longer term moving averages. The further below a peak and falling, the more fearful the market, especially if below longer term moving averages.

High/Low Ratio

The high/low ratio consists of the amount of shares hitting 52-week (1 year) highs versus 52-week lows. A higher number of new 52 week highs exceeding lows is bullish or greedy, and a higher number of new 52 week lows is fearful or bearish.

McClellan Volume Summation

The McClellan Volume index compares the amount of volume behind advances and declines in the New York Stock Exchange. If the breadth is towards the lower end of its range over the past 2 years, the sentiment is seen as fearful. If the breadth is towards the higher end of its range over the past 2 years, sentiment is seen as greedy.

Shiller P/E

The Shiller P/E measures the Price/Earnings on a market wide basis. When prices for shares rise versus earnings, the Shiller P/E rises. When prices for shares fall versus earnings, the Shiller P/E falls. The higher the Shiller P/E is, the greater the chance of overvalued shares. When the Shiller P/E is lower, the chance of shares being undervalued rises. The Shiller P/E should be compared to the mean, which is historically around 16.

An above average and rising Shiller P/E indicates a growing or expanding overvalued market. Buyers should be aware that a downturn in the market may mean the market is correcting. A sharp downturn may accompany a recession. Owners of assets should either sell out or short sell.

A below average Shiller P/E indicates a market with potentially undervalued assets. Sellers should be aware that the market has already sharply corrected or receded into deeply undervalued territory. Buyers are likely to come in scooping up shares for a “deep discount”. A turn upwards from an undervalued trough may indicate that shares should be bought.

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